How Traders Use Cryptocurrency Arbitrage to Make Profits

While some blockchain enthusiasts embrace the technology for its role it can play in improving our industries, others see the tidal wave of digital assets as an opportunity to cash in. Initial Coin Offerings (ICO) have drawn the attention of millions of investors representing billions in funding over the years, but while investing in these projects represents a long-term commitment, there are other ways to profit off the influx of tokens in the marketplace.

Traders and speculators of a more adventurous persuasion are jumping on the opportunity to trade these crypto-assets, enjoying both their volatility while also lamenting their lack of liquidity. For these reasons, trading in the cryptocurrency space has been left to smaller trading accounts, especially since most exchanges previously have had restrictions on the amount of money that can be withdrawn at any moment in time. What has emerged, however, is the growth of an arbitrage trading trend that has made significant gains for many traders.

Cryptocurrency Arbitrage Defined

Arbitrage is the simultaneous buying and selling of an asset class on different markets in order to profit from a price discrepancy between them. For example, a trader might notice that a specific token is selling for less on Exchange A than on Exchange B. An arbitrage trader would buy said token on Exchange A and sell it for a higher price on Exchange B, making a risk free profit in the process.

Arbitrage has existed for a while, especially in the stock, bond, and foreign exchange markets. However, as financial technologies have advanced, it’s become harder to spot and take advantage of price differences in these traditional markets. Only institutional trader’s at large firms have the technology as well as the amount of capital to profit from whatever minute price-differences exist in the traditional markets, leaving most retail traders out of the loop.

Lucrative arbitrage opportunities still exist in the cryptocurrency world, however, where the rapid influx of new tokens, exchanges, and projects help create an environment rife with pricing inefficiencies.

Why Price Differences Occur

Arbitrage opportunities occur usually because of the difference in trading volume between separate markets. Markets and exchanges that have high trading volumes for tokens that have reasonable liquidity are usually less expensive, while markets where there is a limited supply of a particular token will often be more expensive. Traders that instantaneously purchase from more liquid markets and sell on less liquid ones can theoretically profit from the discrepancy.

At the same time, opportunities could exist in the opposite direction, buying on smaller exchanges and selling on larger ones. However, even if a trader identifies a possible price difference between exchanges, one would still need to take into account the fees for trading the coin, costs for withdrawing/depositing a coin, as well as any potential blockchain network fees all on top of the time it takes to perform the trade.

In other cases, cryptocurrency prices can also vary across countries due to supply and demand. From a regulatory perspective, different countries have different laws surrounding cryptocurrency, which may lead to differences in price. It also tends to be more difficult to pull off buying and selling tokens across different countries.

The most noticeable instance of this is called the “Kimchi Premium”, which saw the price of bitcoin (BTC) in South Korea rise to rates 50% higher than global prices during the beginning of 2018. Even when prices are more level, demand for bitcoin tends to produce recurring premiums in the nation.

Another major cause of arbitrage opportunities that are frequently not recognized is new listing arbitrage opportunities. When a token gets listed on a large exchange, there is a window of opportunity for arbitrage due to the newfound buy demand for users on that platform. This temporary price difference is a big source of profit for savvy traders.

One famous example was the Binance listing with Nano (formerly known ad Raiblocks). Before it’s new listing, Nano was only available on two exchanges, Mercatox and BitGrail. On February 2nd, 2018, Binance listed NANO on its exchange. According to CoinMarketCap’s charts, the highest price for NANO in BTC was 0.0021. However, on Binance’s listing, the highest price for Nano was 0.0029 BTC. Many traders bought NANO specifically because it was going to be listed on Binance, knowing full well that it would be the perfect opportunity to cash on a price surge.

Types of Arbitrage

Now that we’ve covered why arbitrage occurs, it’s worth looking into the main methods or strategies traders use to beat their competition. 

1. Regular arbitrage: Simply buying and selling the same asset simultaneously across different markets.
2. Triangular arbitrage: This involves taking advantage of price differences between three different currencies. For example, one can buy bitcoin in Japan, sell the bitcoin for US dollars before finally exchanged the US dollars back into Yen for a profit.
3. Convergence arbitrage: Requires buying a token from one exchange where it is undervalued and short-selling the same token at a separate exchange where it’s overvalued. One the market corrects itself and prices converge in the middle, the difference is your profit margin.
4. Future Index Arbitrage: Thanks to bitcoin futures which came into existence in 2017, some exchanges allow you to purchase these futures. Experienced traders can find opportunities examining the interest rate on these futures contracts and capitalize on any mispricing’s.

Risks In Crypto-Arbitrage

Although arbitrage seems like an almost guaranteed way to make money, the young and volatile nature of the crypto-market could create situations where it’s hard to take advantage of these chances, possibly getting stuck into losing situations due to poor liquidity. Here are some of the main risks traders evaluate.

Competition Risk

Just as arbitrage became less and less profitable in traditional financial markets because the competition became overcrowded, so too is there a possibility of the cryptocurrency markets becoming saturated with wannabe arbitrage traders. Arbitrage opportunities are inversely correlated with the number of traders, so as the popularity of blockchain continues to rise, so to do traders need to worry about their future competitors.

Slippage

In financial markets, slippage refers to the difference between the expected price thought you sold at and what it actually executed at. This usually is because of things such as internet delays or confirmation times, but it’s becoming more prevalent that as trading becomes more popular, existing platforms are having trouble meeting this demand — resulting in slower connection speeds, which compounds the slippage issue.

Volatility Risk

Unlike most investors, arbitrage traders worry not that volatility will increase,but rather that volatility will decrease over the coming years. If the price of mainstream cryptocurrencies become stable, price discrepancies will stabilize as well.

Liquidity Risk

Certain obscure altcoins could have liquidity issues, making it hard to buy and sell them in large quantities. This is one of the reasons why cryptocurrency arbitragers tend to be smaller, retail traders, as the levels of liquidity are far too small for large institutions to find worth their time. It’s also worth noting that many exchanges have withdrawal limits on your tokens, making it difficult to cash in a larger trade, further exposing your assets to changes in valuation.

Conclusion

Cryptocurrencies are perhaps the last great hope for retail arbitrage traders looking for opportunities. While economists argue that arbitrage provides a healthy service to our markets — improving liquidity levels while correcting price discrepancies — the management of many of these blockchain companies would instead portray these traders and vultures feeding off of volatility. Regardless, traders have a variety of methods of making a profit in this sector, but it seems unlikely that these opportunities will remain for long as more players are jumping onto the scene.